Life insurance is a
powerful and positive charitable tool—but only if
used properly in the right circumstances by a charitable
organization that is prepared to screen, monitor and treat
its insurance investments as it treats other investment
assets. There are literally dozens of legal, creative and
ethical ways that life insurance can benefit
charities.

Recently, however,
promoters have been approaching charities with a concept
that enriches private investors more than the charitable
organizations. It is called CHOLI, an acronym for
Charitable-Owned Life Insurance and allusion to COLI,
Company-Owned Life Insurance. Promoters claim that CHOLI is
“a cash windfall for charity—without paying
anything at all.”

CHOLI does not refer to
the classic situation where a charity is given or purchases
policies on the life or lives of key supporters with the
intent to buy and hold. CHOLI denotes highly complex and
speculative arrangements in which investors
“borrow” the insurable interests of charities
to enable them to do something the law does not allow them
to do directly—to speculate on the lives of the
organizations’ older, wealthy and generous
donors.

CHOLI seeks to enable
strangers to engage in what amounts to statistical gaming,
gambling on the rate of deaths of a select group of elderly
insureds. In most of these “dead pool”
arrangements, there is a certainty that third-party groups
of investors (primarily investment banks, insurance
companies and hedge funds) will receive their shares of the
“return on investment” sooner—in
obscenely greater amounts—than the charitable
organizations for which the arrangements are ostensibly
(but not really) designed.

By sidestepping or, in
some cases, actively instigating changes to weaken
insurable interest laws that have, for very sound public
policy reasons, survived for hundreds of years, investor
groups hope to make what was intended to provide security
into a security and convert human life into a mass
commodity investment.

This commentary will help
you decide when to advise the charity to reject certain
life insurance proposals outright and when to recommend
that the organization give the proposal full and serious
consideration.

What Is CHOLI and How Does It Work?
Although there are many variations on this theme,
essentially, CHOLI works like this: An investment bank
issues securities that investors purchase. The money from
the sale goes into a trust (established by the
participating charitable organization). The trustee uses
trust funds to buy single-premium immediate annuities on
the lives of wealthy, and typically older (ages 70 to 90),
donors provided by the charity. The stream of annuity
payments is used to buy life insurance on the same
donors’ lives. Supposedly, the annuities will produce
sufficient income to not only pay the life insurance
premiums, but also provide a sufficient current fixed
return to the investors on their investment, at least until
the donor dies and the insurance proceeds are paid.

At the death of an
annuitant/insured, the “life only” annuity
payment ceases. The insurance proceeds are paid to the
trust, and the investors recover their investment from the
death proceeds received by the trust. If there is any death
benefit remaining at that point, it is paid to the
charitable organization.

Promoters estimate that
the charity’s share of the death proceeds will be
between 5 percent and 7 percent of the initial face amount.
(No, that’s not a misprint. According to the
marketing materials of the promoter, the charity—at
most—gets between five and seven cents on the
dollar!) It’s almost as if the promoter was paying
the organization a commission to enable what—without
the charity being involved—would in most states be
illegal, as well as unconscionable.

Seldom do the promoters
fully disclose to the charity or the insureds the names of
the initial (or secondary market) investors, what is in it
for them, or the full range of risks and potential costs to
the charity and its insured patrons. Legal opinion letters
rarely, if ever, offer comment on the probability of the
charity’s economic success.

A Free Ride Offer for Charities
It is easy for a charitable organization to be seduced by
possible profits from CHOLI-type schemes and “rent
out” its charitable insurable interest and tax-exempt
status to unscrupulous promoters and investors. And the
charitable organization may ignore or never see how, or to
what extent, third-party participants (investors) benefit
from the “partnership.” The organization may
appreciate only the risk it is taking by allowing its
tax-exempt status to be used to enable that up-front
private enrichment.The Hidden Costs to the
Charitable Organization
Charitable organizations that have been inflicted with
legal and ethical but overly-optimistic charity-owned life
insurance arrangements often find that premiums that were
to have “vanished” not only never did, but that
they climbed to such embarrassing levels that the
charities’ relationships with the insured donors were
strained or even threatened. In some cases, charitable
organizations become victims of a scheme such as charitable
split dollar (shut down by IRS Notice 99-36 and by Code
Section 170(f)(1) that imposed penalties on such
arrangements). These plans are similar to one that prompted
Sens. Chuck Grassley and Max Baucus to state in Senate Bill
993,
“These arrangements do more to facilitate
investment by private investors in life insurance than to
further the charity’s tax-exempt purposes”
and that these are “snake-oil salesman taking
advantage of tax-exempt organizations to line their own
pockets with life insurance schemes.”

In addition, a charitable
organization that participates in this arrangement may be
faced with an unpleasant call from its state attorney
general, concerned that it has “partnered” with
private investors whose motive is other than a detached,
disinterested generosity.SOLI—CHOLI’s
Cousin
A variation of CHOLI, called Stranger-Owned Life Insurance
(SOLI), suggests that a charitable organization buy one or
more financed policies on the lives of donors with the
express intent of selling those policies to a life
settlement company at the earliest possible date. SOLI has
been condemned by the National Association of Insurance
Commissioners (NAIC), the National Conference of Insurance
Legislators (NCOIL), the Life Insurance Settlement
Association (LISA), the American Council of Life Insurers
(ACLI) and numerous states’ insurance departments,
and it has resulted in many policy rescissions.How Do You Analyze a
Proposal?
Asking the following questions will significantly increase
the probability of a positive outcome. As an advisor, you
should refuse to go further on a proposal when you reach
the limit of your comfort level. But remember that you do
have a professional responsibility to the donors and to the
charitable organization to objectively and professionally
examine reasonable proposals.

Start with a background check: Ascertain
the reputation of the person trying to sell the insurance.
Demand a copy of the seller’s educational,
experiential and professional background. Check with
charities that have actually implemented this
arrangement—with this marketer—to find out
their experiences, successes, problems and concerns. Ask
for a written report on how many of these plans the seller
has put in place.

Require clear and full explanations:
Demand a step-by-step outline of the process and make a
list of the questions you have. Be particularly concerned
if the plan’s success is based on a multiplicity of
assumptions (are they reasonable?) or “multiple
moving parts,” the failure of any one of which could
thwart the objectives.

Confirm that you are dealing only—and
directly—with reputable, top-rated insurers:
Insist on seeing information based only on the direct
backing of a major and well-known highest rated insurer.
Require a letter from the general counsel of that company
assuring the charity that the tax and other representations
provided to you are correct.

List key assumptions: Make a list of
assumptions or variables that, if they do not work as
projected, could significantly affect the proposal’s
outcome.

Draw up a list of the
disadvantages and exposures the charity and its donor(s)
may face under the proposal. Demand that the seller provide
a best/worst/probable case range of rewards and costs. What
is the maximum downside (or upside) if interest rates,
mortality assumptions and the cost of insurance
increase—or decrease—significantly beyond
anticipated limits?

Require a written backup plan and/or detailed exit
strategy: Insist on an estimate as to any charges,
penalties or other costs that will be incurred. Separate
guarantees and specific promises from projections. To the
extent death benefits are not guaranteed, or if there is a
change in interest rates, policy performance or mortality
costs, there is a significant risk that a premium-financed
life insurance program will not only disappoint and fail to
meet anticipated goals, but also put the charity’s
other assets in jeopardy.

Ascertain and reassess the charitable
organization’s risk-taking propensity:
Leverage is a double-edged sword. Borrowing has the
potential for great rewards—but equally great losses.
Decide in advance how great the charity’s tolerance
is and what will happen if implementation of the proposal
entails risks beyond acceptable levels for the charity. Go
slow on debt!

Determine legal and tax exposures: Do not
sign a nondisclosure agreement. Such agreements are almost
always an indication that the promoter doesn’t want
you or the charity to share information with other
knowledgeable advisors.Investigate to see if the
proposal entails securities/UBTI/private benefit/private
inurement type issues:If the organization is to
remain exempt, any private benefit arising from a
particular activity must be “incidental” in a
qualitative and quantitative sense to the overall public
benefit achieved by the activity.

Check state law regarding insurable
interest: Ensure that the charity has the
requisite insurable interest, a major legal concern.

Discuss the psychology involved: Does a
donor have to die for the organization to profit? How will
its supporters react when they know the organization has a
vested interest in their premature deaths (i.e., the
organization is betting against donors’ longevity).
Would the supporters’ answers change when it is
discovered that strangers will end up having a financial
stake in their life expectancies and that the organization
will probably lose money or never collect what is expected
if they live too long? How will supporters feel when they
find that the investors will have the right to obtain
confidential financial and health information on plan
participants—in some cases monthly—for the rest
of their lives? Would the supporters object if they knew
that the policies on their lives may be sold by the present
investors to other (perhaps less reputable) investors in a
manner similar to the turnover in mortgages?Gauge your loan
obligations:Demand—at the
outset—a complete set of the debt instruments,
contracts or other legal instruments that the organization
will be required to sign. Be particularly sensitive to any
collateral beyond the policy that the organization will
have to pledge, or other guarantees it will have to make.
Consider if the organization will have to borrow money to
finance insurance premiums and how that debt arrangement
will affect the charity’s credit status.Run the
numbers:No one has proved that
CHOLI will really benefit a charity—or to what
extent. What are the up-front fees? What are the likely
annual administration, legal and accounting costs? What
does the charity’s independent counsel/actuary study
show? (It is essential to spend the money to have the
economics and tax claims of the proposed arrangement
independently checked and verified.)

Who are the initial
third-party investors? Who will those investors sell their
interests to if another more profitable use of the
investment comes along, or if they believe this investment
is no longer profitable?

The Bottom Line
Objectivity, enhanced knowledge, uncommon common sense,
open-mindedness, and more than a dash of personal integrity
and courage will help you identify and distinguish between
proposals that are pure alchemy and those that are true
gold and make the right decisions on how to maintain the
balance. Life insurance that is bought and held can help a
charitable organization fulfill its charitable goals to a
degree that might otherwise not be possible—but only
if it is used wisely.

Author BioStephan R. Leimberg, J.D., is CEO of Leimberg
Information Services Inc., an e-mail and database service
providing information and commentary on tax cases, rulings
and legislation for financial services professionals. He is
also CEO of Leimberg and LeClair Inc., an estate and
financial planning software company. He is co-author of Tax
Planning With Life Insurance and has addressed the
Heckerling Tax Institute, the Notre Dame Law School Tax and
Estate Planning Institute, ALI-ABA’s Sophisticated
Estate Planning Techniques course, ALI-ABA’s Planning
for Large Estates course, the NYU Tax Institute, the
National Association of Estate Planners and Councils’
national conference, the AICPA’s National Estate
Planning Forum, and Duke University Law School’s
Estate Planning Conference. His e-mail newsletter/database
www.leimbergservices.com is used daily by thousands of
estate, financial, employee-benefit and retirement planning
practitioners.

Please call Jeff W.
Anderson, J.D. at 423-439-5352, or e-mail us at
andersjw@etsu.edu
,
for more information.